Coach Inc. – Are Things Really That Bad?
Overview
Founded in 1941, Coach Inc. has become one of the largest retailers of fine accessories and gifts in the United States. COH ended fiscal year 2013 with 351 retail stores in its North American segment alone, comprising more than 950 thousand square feet. COH also has 193 factory stores in North America and over 200 stores across China, Japan and Malaysia. Just over 30% of the company's sales are derived from stores located outside of the United States.
The company targets style conscious women and men primarily between the ages of eighteen and forty-five. Coach's target customers are mainly middle-to-high income households, while there has been some discounting in recent quarters targeting more moderate income households in an attempt to boost sales. This could prove to be a risky and potentially damaging strategy if it continues. Overall, however, the firm's merchandising, production sourcing, pricing and main retail store locations have been aimed at a mid-to-high income customer base. Coach offers high-quality, trendy, in-season designer apparel and accessories, including handbags, small leather goods, footwear, jewellery, sunware, watches and fragrances at prices that are 20-60% higher than comparable poorer quality goods. COH also offers higher quality, and higher priced, wearables and travel bags.
Recent Financial Highlights
Almost overnight, changes in customer preferences, competitor prices, and competitor product line launches left coach frozen in its tracks. That is, sales per share decreased 5.5% year-over-year to $3.94 in Mar 2014. Net earnings decreased 20% year-over-year to $191 million in Mar 2014, down from $221 million in Mar 2013. Per share net fell 36% from Dec 2013 and 19% from Mar 2013. What is most discouraging is that the weakness in sales and earnings occurred even as the economy showed signs of strengthening. The company does, however, continue to authorize share repurchases through 2014. For the first nine months the company repurchased and retired 10,239 shares, or $524,926 of common stock, at an average cost of $51.27 per share. For the first nine months of fiscal 2013, the company repurchased and retired 7,066 shares, or $400,000 of common stock, at an average cost of $56.61 per share. As of March 29, 2014, Coach had $836,701 remaining in the stock repurchase program. Coach is also expected to maintain stable dividends.
Purchase Considerations
We believe that COH derives a competitive advantage by offering a reasonably wide assortment of high quality products within its merchandise categories in pleasant, trendy and easy to shop store formats. Its strategy is to offer exceptional styles, quality, warranties and value to target customers by offering an ever-changing, "fresh," and fun mix of products at acceptable price-points.
COH has gained enormous mainstream appeal across a wide set of customers, young and old, over the last 10 years. While we have seen many of these customers defect to other retailers in recent quarters, the firm's core customers and greater numbers of international customers will likely continue to shop at the store. At the same time, the company has been successful adjusting its capital structure (virtually eliminating its debt position), which will free up future cash-flows for greater dividends and share repurchase activities. We continue to like the brand, operating and financial strength of the business and remain impressed by management's ability to preserve shareholder returns. We also like the idea of owning a company that is helped on the long-end by continued strength in the global economic environment.
Cautionary Notes
One reason for caution (depending on investment philosophy that is) is that the stock has recently been pounded in the market and is trading at 52 week lows. There are questions about whether COH's product lines have become faddish and that many customers have outgrown their products. Evidence of this rests in the fact that some of COH's key competitors (e.g. Michael Kors) have maintained relatively stronger foot traffic. Some customers have also voiced a shift in preference for competitors' products given trendier product lines and cheaper price points. Such concerns are legitimate and if customers continue to cut back on purchases, there will be fewer profits for COH.
Free Cash-Flow Valuation
Below we present a simple Free Cash-Flow Valuation of Coach. The valuation is conducted in three steps, we:
Estimate the required rate of return (r)
Estimate the firm’s free cash-flows
Calculate the present value of expected future free cash-flows
Required Rate of Return
The required rate of return on the stock is a function of the 10-year government bond rate; the company’s Beta, and an estimate of the “market risk premium.” Assumed input values are presented below.
Risk free rate = 2.47%
Beta = 1.15
Equity risk premium = 5%
Required rate of return = 2.47% + 1.15(5%) = 8.2%
Free Cash-Flows
Here, we estimated free cash-flows using various time series econometric processes using data from the past 10 years. The center line represents the “best” statistical estimate of the firm’s future free cash flows over the next 10 years. The upper and lower lines capture a 50% confidence interval. That is to say, we are 50% confident that the firm’s free cash-flows will lie between this upper and lower bound.
Free Cash-Flows--Historical, Sample Path, High, Medium, and Low Projections
Data is also presented in tabular form.
Free Cash-Flows--Historical, Sample Path, High, Medium, and Low Projections
| Historical | Projections | ||||||||||||||
| Jun09 | Jun10 | Jun11 | Jun12 | Jun13 | Jun14 | Jun15 | Jun16 | Jun17 | Jun18 | Jun19 | Jun20 | Jun21 | Jun22 | Jun23 | |
| High | 1.75 | 2.88 | 2.94 | 3.53 | 4.1 | 3 | 3.7 | 4.0 | 4.4 | 4.7 | 5.0 | 5.4 | 5.7 | 6.0 | 6.3 |
| Medium | 1.75 | 2.88 | 2.94 | 3.53 | 4.1 | 3 | 3.2 | 3.5 | 3.7 | 3.9 | 4.1 | 4.4 | 4.6 | 4.8 | 5.0 |
| Low | 1.75 | 2.88 | 2.94 | 3.53 | 4.1 | 3 | 2.8 | 2.9 | 3.0 | 3.1 | 3.2 | 3.4 | 3.5 | 3.6 | 3.8 |
Present Value of Expected Future Free Cash Flows
Given Coach’s recent pullback in sales and earnings, we stray on the side of caution and use our “Low” free cash-flow projections to estimate the value of the company. Assuming a terminal growth rate of 3% in 2024 and a terminal discount rate of 8.2% (based on our required return estimate above), Coach will have a terminal value of $75.27 in 2023. Discounting this to the present at 8.2% equals $34.23. If we then add the present value of free cash flows between 2014 and 2023 ($20.97) to this estimate, we derive a final value for Coach of $55.20. Given a current stock price of $34.25, this suggests that Coach is undervalued by about 61%.
Conclusion
Running through this quick exercise, it’s hard not to see value in Coach. Only time will tell, however, whether our low free cash-flow projections are in fact “low enough,” and whether the company has the competitive might to overcome its recent challenges.
